Foreign Direct Investment Foreign Direct Investment (FDI) Involves a 10% or more ownership of an overseas business enterprise. Foreign direct investment Multinationals buy or build new plants or equipment overseas Shift funds abroad to expand a subsidiary Reinvest the earnings of overseas subsidiary Transfer intangibles Multinational enterprises Vertical and Horizontal MNEs Vertical integration Fragmented production process vertically linked across countries. To ensure supply of foreign raw materials, and intermediate products To take advantage of factor price differences across countries Vertical and Horizontal MNEs Horizontal integration With headquarter in one country, production plants are duplicated multiple countries Knowledge created at headquarters is used at plants in multiple countries Horizontal integration allows MNEs to exploit their monopoly power adapt products to host conditions and tastes to ensure consistent product quality to exploit economies of scale In production, financing, R&D, market information to get around trade restrictions (market access) to avoid costs of transporting exports (to lower trade costs) Determinants of FDI According to Dunning (1988) there are three necessary conditions for FDI to take place. FDI takes place there must be three basic advantages: ownership, location, and internalization. Ownership advantages: held exclusively by the multinational Ownership of Knowledge-based firm-specific assets : patent, blueprint, trade secret, human capital, reputation, copyrights, trademarks, managerial skill, etc. Knowledge based assets can easily be transferred to additional production facilities at very low cost. Ownership of other assets like capital Location advantages: advantages gained from the host country. Particular advantages of the host to the multinational enterprise The Host must exhibit a Location Advantage for an MNE to undertake FDI Any of the following motivates MNEs to undertake FDI: The host has large market The host has cheap labor or other resource The host has technology that the MNE wants to source The host can be used as a strategic export platform Internalization advantages the gains that a multinational has by using its firm specific assets internally rather than licensing or selling them to host country or other firms MNE activities are concentrated mostly in knowledge based assets. If the knowledge based secrets are not carefully guarded within the firm, their value can be easily dissipated. Licensees who learn the secrets can defect from the MNE and start their own business. Motives for Undertaking FDI Activities Dunning (1993) identified four MNE motives for undertaking FDI activities: resource seeking, market seeking, efficiency seeking, and strategy seeking The resource seeking FDI: the host must have resources that the multinational is seeking such as raw materials, intermediate products, labor, technology, patents, etc. Usually involves vertical FDI. Market seeking: market access is the main motive. It involves horizontal FDI: the production process of the MNE is duplicated at the host location. The size of the market, the rate of growth of the market, host proximity to other markets, and/or host country trade restrictions are important. Efficiency-seeking: FDI seeks to take advantage of economies of scale the MNE can duplicate a plant abroad without duplicating certain fixed costs achieving multi-plant economies of scale. MNE can transferring part of its activities to countries with lower labor costs. Strategic position seeking: to consolidate and strengthen the long-term competitive edge of the MNE, it will engage in FDI activities at a strategic location and time. Potential advantage of FDI to the source country Increase in profit to multinationals A rise in wealth and national income for the source country Potential advantage of FDI to source country Increased capacity to source overseas knowledge and technology Potential advantage of FDI to source country Production and distribution efficiency Potential cost of FDI to the source country Loss of domestic jobs But the source country would have likely lost these jobs to foreign competition any way Domestic small and intermediate firms can lose business if the mne shifts its business to overseas firms. Potential costs of FDI to the source country Export advanced technology to combine with cheaper factors abroad the source country may lose technological advantage But mncs conduct R&D activities mostly in source country Potential costs of FDI to the source country Taxation Source countries may have difficulty taxing MNE income stemming from foreign operations Monetary Policy MNEs can circumvent domestic monetary policies because of their access to international capital markets Benefits of FDI to the host country If the host country consumers pay a price less than the autarky average cost, the host benefits, because the average cost represents the true resource (opportunity) cost of production. Benefits of FDI to the host country If the host was importing the product prior to the MNE involvement: For the host to gain, the price charged by the MNE should be less than the import price. Potential advantages of FDI to the host country Increased output More capital complementing local resources can raise output. Increase in labor income More output more income for labor Increased employment Increased exports and foreign exchange Potential advantages of FDI to the host country Increased tax revenues From profits and the increased income of others Access to technical and managerial skills provision of human capital Potential advantages of FDI to the host country May weaken the power of host firms characterized by monopoly. Potential costs of FDI to the host country Deterioration of the terms of trade Increased exports by MNEs (from the host country), if large enough, drives down export prices. Deterioration of the recorded (by the MNE) terms of trade Usually, in transfer pricing the value of exports is understated and the value of imports is overstated Potential costs of FDI to the host country A fall in domestic savings The inflow of foreign capital could discourage domestic savings Potential costs of FDI to the host country A fall in domestic investment If the foreign firm finances FDI by borrowing money from the host country it raises interest rates in the host country the rise in interest rates discourages investment by domestic firms. Potential costs of FDI to the host country May lead to BOP deficit Repatriation of profits from host country to source country by the MNE Imports of Inputs by MNE to host country Potential costs of FDI to the host country If MNEs intervene in host country politics, the host may lose control of domestic policy. fdi may cause unemployment in the host country if MNEs bring in capital intensive techniques and displace local firms. Potential costs of FDI to the host country impose monopoly power A large MNE may undercut a competitive local industry and drive out host country firms. No new skills will be acquired by host country workers if the MNE reserves jobs requiring expertise and high level skills for headquarter workers. Controversy over Transfer Pricing Transfer pricing Both host and source governments worry that MNEs may illegally manipulate prices paid between subsidiaries to avoid taxes Transfer pricing illustrated Germany (tax rate 48%) Computer produced by parent firm for $2000. Sold to Irish subsidiary for $2000. German tax paid: $0. Ireland (tax rate 4%) Irish subsidiary resells the same computer to US subsidiary for $2500, earning $500 profit. Irish tax paid: $20. United States (tax rate 34%) US subsidiary sells computer at cost, for $2500. No profit is earned. US tax paid: $0. Irish subsidiary then lends money to US subsidiary for expansion

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